Bear Markets Lay Bare Investors' Pessimism

The dreaded words 'bear market' strike fear into the hearts of many investors. A bear market happens when investment prices drop by more than 20% from their most recent high. There

James Royal, Ph.D.

The dreaded words 'bear market' strike fear into the hearts of many investors. A bear market happens when investment prices drop by more than 20% from their most recent high. There can be bear markets for a market as a whole, such as in the Dow Jones Industrial Average or the S&P 500, as well as individual stocks.

While 20% is the threshold, bear markets often plummet much deeper than that over a sustained period, not all at once. Though the market has a few occasional 'relief rallies,' the general trend is downward. Eventually, investors begin to find stocks attractively priced and start buying and the market hits bottom, officially ending the bear market.

Bear markets are characterized by investors' pessimism and low confidence. During a bear market investors often seem to ignore any good news and continue selling quickly, pushing prices " and sentiment " even lower.

By contrast, in a bull market, investors are optimistic and reward even modestly good news with higher stock prices, fueling an upward spiral. Bull markets tend to be much longer than bear markets.

While investors might be bearish on an individual stock, that sentiment may not affect the market as a whole. But when the market turns bearish, almost all stocks within it begin to decline, even if individually they're reporting good news and growing earnings.

» Read more: Here's what you need to know when the market crashes

How long do bear markets last?

Bear markets are the bigger, more ferocious versions of 'market corrections,' which are typically brief, shallow downturns in the market. Of course, what at first seems to be a correction may quickly become a bear market, if stocks continue to fall. While every downturn is different, investors categorize each by its depth. For example:

Corrections are often relatively short and shallow. There have been five corrections of at least 10% since the 2008-2009 financial crisis, with stocks declining an average 14.3% during each period.Bear markets tend to go on longer and plunge deeper. The three bear markets since 1987 have dipped 46.5% over an average time period of 1.4 years.Meanwhile, the last three bull markets have lasted nearly nine years on average.The S&P 500 has experienced 11 bear markets in the last 75 years.A bear market in graphics

As the name suggests, bear markets can be scary. To get a sense of what a bear market looks like graphically, take a look at the market from 2000-2003 as represented by the S&P 500 Index. By late 2000 the U.S. economy was verging on a recession.

On this chart you can see the market crash in March 2000, which helped kick off the longer-term bear market, as the dot-com boom busted. However, despite this crash, it wasn't until later that year that the market made a sustained move down. The bear market in the S&P 500 didn't reach its lowest level until late 2002, about 2.5 years after its bull market peak.

How does that compare to the most recent recession? To borrow a famous quote: 'History doesn't repeat itself, but it rhymes.'

Here the market didn't show a clear breakdown until October 2007, but then it moved quickly. Stocks moved lower for all of 2008 " the classic behavior of a bear market " before finally bottoming in March 2009.

Finally, for contrast, have a look at the 2015-2016 correction, which was precipitated over concerns about Chinese debt and rising interest rates, rather than an America-wide recession.

This correction is not all that pronounced, especially in retrospect. From its November 2015 high to its February 2016 low, the market dropped more than 13%, not enough to be a bear market. That decline defines it solidly as a correction, and the market continued moving higher not long after. It was a key time for discount shoppers to emerge for cheap stocks.

What causes a bear market?

A bear market often occurs just before or after the economy moves into a recession.

Investors carefully watch key economic signals " hiring, wage growth, inflation and interest rates " to judge when the economy is slowing. When they see a shrinking economy, they expect corporate profits to decline in the near future and so they sell stocks, pushing the market lower. Investors en masse are good at predicting recessions, so a bear market usually signals more unemployment and tougher economic times ahead.

That was certainly the case for the 2000-2003 and 2007-2009 bear markets. But the infamous 1987 bear market was a different beast, as the Dow Jones Industrial Average plunged 22.6% in a single day. It was a crash for the ages, and the drop technically put the market into a bearish funk. The market sank 33.5% in short order, but a recession was nearly three years away. With the strong underlying economy, this bear market was one of the shortest on record, just 101 days.

So while bear markets often foretell a recession, they don't always do so.

How to tell if a bear market is ahead

Bear markets look obvious in retrospect, but as the saying goes, 'Nobody rings a bell at the top.' It's not easy to determine when stock prices have peaked and you're entering a bear market or to predict if a relatively mild correction will turn into a full-blown bear.

Still, investors do have some rules of thumb. One of the best ways to determine whether a bear market is likely is to watch interest rates. If the Federal Reserve lowers interest rates in response to a slowing economy, it's a good clue that a bear market could be on the way. But sometimes a bear market begins even before interest rates are lowered.

For example, look at when the Fed lowered interest rates near the last two bear markets. In January 2001, the central bank dropped rates from 6.5% to 6%, while the bear market officially began in March 2000. The situation was reversed in the 2007 downturn. In mid-September 2007, the Fed dropped rates from 5.25% to 4.75%, and the bear was shortly on the market's heels. Lower interest rates are no guarantee, but they're a guidepost that tougher times might be ahead.

So whenever the next bear market rears its head, you'll want to be ready.

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James Royal, Ph.D. is a writer at NerdWallet. Email: jroyal@nerdwallet.com. Twitter: @JimRoyalPhD.

The article Bear Markets Lay Bare Investors' Pessimism originally appeared on NerdWallet.

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